QE for Dummies

Understanding the most outlandish monetary experiment ever conducted

A PeakProsperity.com reader recently lamented:

I have been trying to get my head around the mechanism of QE. Not being
an economist or experienced investor I don't really understand a lot of
the jargon. The usual simple definition of QE as "thin air money printing" does
not satisfy my need for understanding either. Have hunted for a description
of QE for dummies that leaves me feeling like I get it, but with no luck.
My difficulty is in understanding how thin air money gets into circulation.

So I'm going to do my best to answer this plea in as intuitive and straightforward
a manner as I can. I, too, share the need to understand the mechanism of a
process in order to feel like I have a grasp of it. And I think it's critically
important to understand QE (also known by its full name, "quantitative easing")
and what it really represents. Because it is, without a doubt, one of the
largest market-shaping forces of our times.

Further, it presents extraordinary risks and may well turn out to be a decisive
shaping process for the future, as well. And not in a good way.

Despite its sophisticated-sounding name, QE is nothing more complicated than
the Fed buying "assets" from commercial banks and other private financial
institutions. I put assets in quotes because the Fed does not buy things like
land, Stradivarius violins, diamonds, gold, or silver from these institutions,
but rather various forms of debt.

The main forms of debt purchased are Treasury bills/notes/bonds and Mortgage
Backed Security (MBS) paper.

There could well be other forms, too, but we currently have no visibility
into the composition of the sizable portion of the Fed's balance sheet that
comprises the "other assets" line. I'll get into that in more detail in a
minute.

QE Explained

First, here's the an explanation of QE:

Quantitative easing (QE) is an unconventional monetary policy used
by central banks to stimulate the national economy when conventional monetary
policy has become ineffective.

A central bank implements quantitative easing by buying financial assets
from commercial banks and other private institutions, thus creating
money and injecting a pre-determined quantity of money into the
economy.

Quantitative easing increases the excess reserves of the banks, and raises
the prices of the financial assets bought, which lowers their yield.

The reason that QE differs from normal monetary policy is that, in the normal
case, the purchase of various bond types by the Fed does two things: It lowers
interest rates, and it increases the amount of money in the system.

QE, on the other hand, cannot lower interbank interest rates any further than
they already are, because they are at 0%. So a different name is used for
the process in which the only thing being eased is the quantity of
money. Hence Quantitative Easing (QE).

This is just a fancy way of saying that the central bank, via prior errors
and miscalculations, has found itself stuck in a trap where it has lost one
of its most potent tools: the price of money. And now it can only fiddle
with the quantity of money.

Here's a simple picture that I drew to illustrate just how simple this fancy-sounding
process really is:

When the Fed performs this trick, what happens is that the assets end up on
its balance sheet as - well, assets of course. Luckily the Fed provides reasonable
clarity in a timely manner on the expansion of its balance sheet. So we can
see pretty well what's going on here as it happens.

In graph form, we can see that the Fed's asset balance had been holding steady
at around $2.75 trillion for a bit over a year. But then the latest round
of QE (QE4) began, which has swelled the Fed balance sheet above than $3 trillion
- and it's way to (at least) $4 trillion by year end (2013).

Here's a nice short description of the process of QE:

A central bank [performs QE] by first crediting its own account with
money it has created ex nihilo ("out of nothing"). It then purchases
financial assets, including government bonds and corporate bonds,
from banks and other financial institutions in a process referred to
as open market operations.

The purchases, by way of account deposits, give banks the excess reserves
required for them to create new money by the process of deposit multiplication
from increased lending in the fractional reserve banking system.

The increase in the money supply thus stimulates the economy. Risks
include the policy being more effective than intended, spurring hyperinflation,
or the risk of not being effective enough, if banks opt simply to pocket
the additional cash in order to increase their capital reserves in a climate
of increasing defaults in their present loan portfolio.

The Price of Thin Air Money

At this point you might be thinking, where did the Fed get the money to
buy these assets? The answer to that is simple: It was created out
of thin air. Or ex nihilo, if you want to use Latin to make
it sound more official.

In these modern times, no actual paper money was created and exchanged, of
course; just a few clicks on a computer keyboard. And - voila! - billions
and billions of dollars are created.

There are several critical risks to flooding the world with invented money.
Once we understand them, it becomes clearer how the Fed's decision to pursue
QE has put it in a box, where its available options are becoming fewer and
fewer. And it explains why the Fed is continuing - and will continue until
it simply can't - with its aggressive money printing.

To make our situation clear, we are living through the largest and most outlandish
monetary experiment ever conducted by humans upon themselves. These are extraordinary
times, and no matter how many times the mainstream press tries to convince
you that a rising stock market or a rebounding housing market implies that
we are returning to healthy economic balance, don't fall for it.

The Fed is in uncharted territory, having created a monster it can no longer
control. In the process, it is blowing new asset bubbles that are benefitting
those with first access to the newly-printed money (banks and corporations)
at the expense of savers, pensioners, and anyone exercising fiscal prudence.
This, of course, is creating a vast and growing inequality between the top
1% and everyone else.

When this misadventure in monetary policy ends, as both math and history says
it must, it will be messy, uncontrolled, and very painful for holders of just
about every sort of finanical instrument out there (stocks, bonds, derivatives,
etc). That's why understanding the root causes and risks of QE is so important,
in order to identify the best shelters for protecting the purchasing power
of your wealth through this transition.

Executive summary: Father of three young children; author; obsessive financial
observer; trained as a scientist; experienced in business; has made profound
changes in his lifestyle because of what he sees coming.

I think it's important that you understand who I am, how I have arrived at
my conclusions and opinions, and why I've dedicated my life to communicating
them to you.

First of all, I am not an economist. I am trained as a scientist, having completed
both a PhD and a post-doctoral program at Duke University, where I specialized
in neurotoxicology. I tell you this because my extensive training as a scientist
informs and guides how I think. I gather data, I develop hypotheses, and I
continually seek to accept or reject my hypotheses based on the evidence at
hand. I let the data tell me the story.

It is also important for you to know that I entered the profession of science
with the intention of teaching at the college level. I love teaching, and
I especially enjoy the challenge of explaining difficult or complicated subjects
to people with limited or no background in those subjects. Over the years
I've gotten pretty good at it.

Once I figured out that most of the (so-called) better colleges place "effective
teacher" pretty much near the bottom of their list of characteristics that
factor into tenure review, I switched gears, obtained an MBA from Cornell
(in Finance), and spent the next ten years working my way through positions
in both corporate finance and strategic consulting. From these experiences
I gather my comfort with numbers and finance.

So much for the credentials.

The most important thing for you to know is the impact that the information
that I've now placed on this site had on me. Let's do this as a Before and
After.

Before: I am a 40-year-old professional who has worked his way up to
Vice President of a large, international Fortune 300 company and is living
in a waterfront, 5 bathroom house in Mystic, CT, which is mostly paid off.
My three young children are either in or about to enter public school, and
my portfolio of investments is being managed by a broker at a large institution.
I do not really know any of my neighbors, and many of my local connections
are superficial at best.

After: I am a 45-year-old who has willingly terminated his former high-paying,
high-status position because it seemed like an unnecessary diversion from
the real tasks at hand. My children are now homeschooled, and the big house
in Mystic was sold in July of 2003 in preference for a 1.5 bathroom rental
in rural western Massachusetts. In 2002, I discovered that my broker was unable
to navigate a bear market, and I've been managing our investments ever since.
Since that time, my portfolio has gained 166%, which works out to a compounded
yearly gain of 27.8% for five years running (whereas my broker, by keeping
me in the usual assortment of stocks, would have scored me a 38% return, or
8.39%/yr). I grow a garden every year; preserve food, know how to brew beer & wine,
and raise chickens. I've carefully examined each support system (food, energy,
security, etc), and for each of them I've figured out either a means of being
more self-sufficient or a way to do without. But, most importantly, I now
know that the most important descriptor of wealth is not my dollar holdings,
but the depth and richness of my community.